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What's in this guide
- How an Annuity Works: The Two Phases
- The 7 Types of Annuities Explained
- All 7 Types Side by Side
- Annuity Fees: Every Charge Named and Explained
- How Annuities Are Taxed
- How Safe Is Your Annuity?
- Beneficiary Options and Death Benefits
- Annuities and Medicaid
- When Selling Your Annuity Payments Makes Sense
- Frequently Asked Questions
An annuity is a contract between you and an insurance company. You pay a premium, either as a lump sum or in installments. In return, the insurance company promises to make payments to you, either immediately or at a future date, either for a fixed period or for the rest of your life.
That is the simple version. The reality is that annuities come in many forms, carry different fee structures, different tax treatments, and different levels of risk. Understanding those differences is what separates a smart financial decision from an expensive one.
At their core, annuities exist to do one thing: turn a sum of money into a reliable income stream. That makes them useful for retirement planning. It also makes them relevant when you have a structured settlement or lottery prize paying out over decades and you want access to the full value today.
A Brief History
Annuities have existed in some form since ancient Rome, where the government sold annua (annual payments) to citizens in exchange for lump sum contributions. In the United States, life insurance companies began offering annuities in the 19th century. The modern annuity as a retirement income tool was significantly shaped by the Employee Retirement Income Security Act (ERISA) of 1974 and the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, which established the tax-deferred treatment that makes annuities attractive today.
How an Annuity Works: The Two Phases
Every annuity has two potential phases. Understanding which phase you are in, or which you are buying for, changes everything about how the product works.
Phase One: Accumulation
During the accumulation phase, your money grows inside the annuity contract. You make contributions (called premiums) and the funds accumulate on a tax-deferred basis. This means you pay no income tax on the growth until you withdraw the money.
How your money grows depends on the type of annuity: a guaranteed interest rate for fixed annuities, market-linked returns for variable annuities, or index-linked returns with a built-in floor for fixed indexed annuities.
Phase Two: Distribution (Annuitization)
During the distribution phase, the insurance company begins making payments to you. You can annuitize the contract, meaning you convert the accumulated value into a stream of guaranteed income payments. Alternatively, many modern annuities allow you to take systematic withdrawals without fully annuitizing.
Once you annuitize, the decision is generally permanent. You trade the account value for a guaranteed income stream. The insurance company takes on the investment risk and the longevity risk. That means they pay you even if you live well past your actuarial life expectancy.
The Surrender Period
Between the two phases sits the surrender period, typically 7 to 10 years. If you withdraw more than a permitted amount during this period, you pay a surrender charge. Surrender charges start high (often 7 to 10%) and decline to zero by the end of the period. This is the most important thing to understand before buying any deferred annuity.
| Surrender Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8+ |
|---|---|---|---|---|---|---|---|---|
| Typical Charge | 7% | 6% | 5% | 4% | 3% | 2% | 1% | 0% |
The 7 Types of Annuities Explained
This is where most people get lost. There are seven main annuity types, and within each category there are dozens of product variations. Here is a clear breakdown of each type.
01 Fixed Annuity
Guaranteed rate, zero market risk
The insurance company credits your account with a fixed interest rate for a set period, typically one to ten years. At the end of that period, a new rate is set based on prevailing market conditions. Your principal is protected regardless of market performance.
Key advantage: You always know exactly what you are getting. No surprises.
Best for: Conservative investors who want predictability and principal protection above all else.
02 Multi-Year Guaranteed Annuity (MYGA)
Like a CD, but with tax deferral
An MYGA locks in a guaranteed interest rate for a specific term, usually 3 to 10 years. Similar to a bank CD in concept, but the growth is tax-deferred and the rates are often higher. At maturity, you can renew, annuitize, or roll the funds into another annuity via a 1035 exchange.
Key advantage: Predictable, competitive rates with tax-deferred growth. Rates in 2025 reached 4 to 6% on longer terms.
Best for: People who want a guaranteed rate for a defined period and do not need the money during that term.
03 Variable Annuity
Market-linked growth, higher risk and higher potential return
Your premium is invested in sub-accounts that function like mutual funds. Returns go up and down with the market. Variable annuities offer the highest growth potential among annuity types, but your account value can decline. They also carry the highest fees, including mortality and expense (M&E) charges on top of fund management fees.
Key advantage: Market participation inside a tax-deferred wrapper, often with optional rider protections.
Best for: Growth-oriented investors comfortable with market volatility who want tax deferral and optional income guarantees.
04 Fixed Indexed Annuity (FIA)
Index-linked growth with a built-in floor
Returns are linked to a market index such as the S&P 500, but your principal is protected from loss. In a good year, you capture a portion of the index gain (subject to a cap or participation rate). In a bad year, your account simply earns 0% rather than losing value. The floor is 0%, not negative.
Key advantage: Market upside participation without the downside. One of the fastest-growing annuity categories for this reason.
Best for: Investors who want some market exposure but cannot afford to lose principal.
05 Single Premium Immediate Annuity (SPIA)
Income that starts within 12 months
You hand the insurance company a lump sum (the single premium) and they begin making income payments to you within one to twelve months. The payment amount is calculated based on your age, the premium, the payout option you choose, and current interest rates. Once the payments begin, they cannot be changed.
Key advantage: Simplicity and certainty. You know exactly what you will receive for the rest of your life from day one.
Best for: Retirees who need income immediately and want to eliminate the risk of outliving their money.
06 Deferred Income Annuity (DIA) / Longevity Annuity
Buy now, receive income later
You purchase the annuity today but defer income payments to a future date, often age 75, 80, or even 85. Because payments start later, you get significantly higher monthly income for the same premium. DIAs are essentially longevity insurance. You are betting that you will live long enough to collect.
Key advantage: Dramatically higher monthly income compared to immediate annuities, because the insurance company keeps money if you die before the income start date.
Best for: People who want to insure against the risk of living very long without running out of money.
07 Qualified Longevity Annuity Contract (QLAC)
Reduce RMDs while insuring long life
A QLAC is a deferred income annuity funded from a traditional IRA or 401(k). Under SECURE 2.0, you can contribute up to $200,000 (indexed for inflation) or 25% of your retirement account balance, whichever is less. The key benefit: funds inside the QLAC are excluded from the Required Minimum Distribution (RMD) calculation until payments begin, at a maximum start date of age 85.
Key advantage: Legally reduces your RMD burden while creating guaranteed income for your later years.
Best for: IRA and 401(k) holders who want to lower their RMDs and insure against outliving their savings after age 80.
All 7 Types Side by Side
Use this table to understand at a glance how each annuity type compares across the factors that matter most.
| Type | Risk Level | Growth Potential | Principal Protection | Income Start | Typical Fees |
|---|---|---|---|---|---|
| Fixed Annuity | Very Low | Low to Moderate | Yes | Deferred or Immediate | Low |
| MYGA | Very Low | Low to Moderate | Yes | Deferred | Very Low |
| Variable Annuity | High | High | No | Deferred or Immediate | High (1.5 to 3.5%+) |
| Fixed Indexed Annuity | Low | Moderate | Yes (0% floor) | Deferred | Moderate |
| SPIA | Very Low | None (income only) | N/A | Immediate | Built into payout rate |
| DIA / Longevity Annuity | Low | None (income only) | N/A | Future date chosen | Built into payout rate |
| QLAC | Low | None (income only) | N/A | Deferred to max age 85 | Built into payout rate |
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Annuity Fees: Every Charge Named and Explained
Fees are the single most important factor in determining whether an annuity is a good deal. Most people buying annuities do not understand all the fees involved. Here is every charge you may encounter and what it actually means.
| Fee Type | Who Charges It | Typical Range | Applies To | Notes |
|---|---|---|---|---|
| Mortality and Expense (M&E) | Insurance company | 0.5% to 1.5% annually | Variable annuities | Covers the insurer's cost of providing the death benefit and income guarantees |
| Administrative Fee | Insurance company | $25 to $50/year or 0.1 to 0.3% | Most annuities | Covers record-keeping and contract maintenance |
| Fund Management Fee | Sub-account fund managers | 0.5% to 2.0% annually | Variable annuities | Charged inside each sub-account like a mutual fund expense ratio |
| Surrender Charge | Insurance company | 7 to 10%, declining to 0% | All deferred annuities | Charged on early withdrawals above the free withdrawal amount during the surrender period |
| Rider Fee | Insurance company | 0.25% to 1.0% per rider | Any annuity with optional riders | Charged annually for each rider added to the contract |
| Premium Tax | State government | 0% to 3.5% | Varies by state | Some states impose a tax on the premium at purchase. The insurer typically deducts this upfront. |
The True Cost of a Variable Annuity
A variable annuity with an M&E fee of 1.25%, an administrative fee of 0.15%, a fund management fee averaging 1.00%, and a GLWB rider at 0.75% carries a total annual cost of 3.15%. On a $200,000 account, that is $6,300 per year in fees before you see a single dollar of growth. Always ask for the all-in fee total before signing.
How Annuities Are Taxed
Tax treatment is one of the most important factors in deciding whether an annuity belongs in your financial plan and which type makes the most sense for you. The rules differ based on whether the annuity is qualified or non-qualified.
CFPB Watch
The Consumer Financial Protection Bureau has been monitoring the pre-settlement funding industry. While no specific federal rule has been enacted as of this writing, the CFPB has the authority to designate consumer legal funding as a consumer financial product, which would bring it under federal regulation. This is an evolving area of law. Check for updates if you are considering a funding agreement.
Non-Qualified Annuities (IRC Section 72)
A non-qualified annuity is purchased with after-tax money outside of a retirement account. The principal you contributed is not taxed again when you withdraw it. However, the growth (earnings) is taxed as ordinary income when withdrawn.
The IRS uses a Last In, First Out (LIFO) rule for non-qualified annuity withdrawals. Earnings come out first and are fully taxable before you start receiving tax-free return of principal. Withdrawals before age 59.5 are also subject to a 10% early withdrawal penalty on the taxable portion.
The Exclusion Ratio (SPIA and Immediate Annuities)
When a non-qualified immediate annuity begins paying income, each payment is split into two components using the "exclusion ratio." The formula is: Investment in Contract divided by Expected Return. For example, if you paid $100,000 in premiums and your expected total payments are $200,000, the exclusion ratio is 50%. Half of each payment is a tax-free return of principal and half is taxable income. Once you have recovered your full investment, all remaining payments become fully taxable.
Qualified Annuities (IRA, 401k, 403b Funded)
A qualified annuity is purchased inside a retirement account such as a traditional IRA, 401(k), or 403(b) plan. Because the contributions were made pre-tax, all withdrawals are taxed as ordinary income. There is no exclusion ratio because there is no after-tax basis in the contract.
Qualified annuities are subject to Required Minimum Distributions (RMDs) starting at age 73 for those born between 1951 and 1959, and age 75 for those born in 1960 or later, under the SECURE 2.0 Act.
The 1035 Exchange
If you own an annuity and want to move to a better product without triggering a taxable event, you can execute a 1035 exchange under IRC Section 1035. This allows you to transfer the full value of one annuity directly to another annuity, tax-free.
The key requirements: the transfer must be direct (the funds cannot pass through your hands), the owner and annuitant must remain the same, and the new contract must be issued by a licensed insurance company. A 1035 exchange also resets the surrender period on the new contract, so evaluate carefully.
| Tax Situation | Rule | Legal Basis | Key Point |
|---|---|---|---|
| Non-qualified growth | Tax-deferred until withdrawal | IRC Section 72 | Earnings taxed as ordinary income, not capital gains |
| Non-qualified withdrawals | LIFO, earnings out first | IRC Section 72(e) | You pay tax on gains before recovering your principal |
| Early withdrawal penalty | 10% penalty before age 59.5 | IRC Section 72(q) | Applies to taxable portion only, with some exceptions |
| Qualified annuity withdrawals | 100% taxable as ordinary income | IRC Section 408 / 401(a) | No exclusion ratio. All pre-tax dollars. |
| Required Minimum Distributions | Must begin at age 73 or 75 | SECURE 2.0 Act | 73 for those born 1951–1959, 75 for 1960 and later |
| QLAC exemption | Up to $200,000 excluded from RMD | IRC 401(a)(9), SECURE 2.0 | Defers RMD obligation on funds inside the QLAC until income begins |
| 1035 exchange | Tax-free transfer between annuities | IRC Section 1035 | Must be direct transfer. Funds cannot be received by owner. |
| Death benefit to beneficiary | Taxed as ordinary income on gains | IRC Section 72(s) | Beneficiary options affect how quickly taxes are owed |
How Safe Is Your Annuity?
Annuities are not FDIC insured. Many people do not know this, and it matters. Here is what actually protects your money inside an annuity contract.
State Guaranty Associations
Every state has a Life and Health Guaranty Association. If your insurance company becomes insolvent and cannot meet its obligations, the guaranty association steps in to cover your annuity up to a set limit. This is the primary protection for annuity holders.
| State | Coverage Limit | Notes |
|---|---|---|
| Most states | $250,000 | Standard limit for annuity contract benefits |
| New York | $500,000 | Higher than the national standard |
| Washington | $500,000 | Higher than the national standard |
| New Jersey | $500,000 | Higher than the national standard |
| California | $250,000 | Standard limit |
| Texas | $250,000 | Standard limit |
| Florida | $250,000 | Standard limit |
To verify your state’s specific coverage limits and look up your insurer’s membership status, visit NOLHGA.com (National Organization of Life and Health Insurance Guaranty Associations).
Insurance Company Ratings
The financial strength of the insurer backing your annuity matters significantly. Unlike a bank deposit, your protection depends partly on the company remaining solvent. Three major independent rating agencies assess insurer financial strength:
- AM Best: AM Best: The most insurance-specific rating agency. Look for A (Excellent) or better. Avoid companies rated below B++.
- Moody’s: Moodys: Look for A2 or higher for annuity issuers.
- S&P: Standard and Poor’s: Look for A or higher.
Diversification Tip
If you plan to hold more than your state's guaranty association limit in annuities, consider spreading contracts across multiple highly-rated insurance companies. This maximizes your guaranty association coverage and reduces concentration risk with any single insurer.
Beneficiary Options and Death Benefits
What happens to your annuity when you die depends entirely on how the contract is structured and which payout option you chose. This is one of the most important conversations to have before purchasing.
| Payout Option | What Happens at Death | Monthly Income | Best For |
|---|---|---|---|
| Life Only | Payments stop. Nothing passes to heirs. | Highest | Single person with no dependents and no estate planning goals |
| Life with Period Certain (10 or 20 years) | Payments continue to beneficiary for the remaining guaranteed period | Moderate | Those who want guaranteed minimum payout regardless of lifespan |
| Joint and Survivor | Payments continue to surviving spouse, often at 50%, 66%, or 100% | Lower than Life Only | Married couples who need income to continue for both lives |
| Life with Cash Refund | Beneficiary receives the premium minus payments already received | Lower | Those who want heirs to receive at least what they paid in |
| Fixed Period | Payments continue to beneficiary for the remaining fixed term | Varies | Those who want income for a defined term only, not for life |
Annuities and Medicaid
This is a topic most annuity guides skip entirely. It should not be skipped.
When an individual applies for Medicaid to cover long-term care costs, annuities are treated differently depending on whether they are in the payout phase and whether they meet specific Medicaid-compliant requirements.
Medicaid-Compliant Annuities
A Medicaid-compliant annuity can be used as part of a spend-down strategy to help a spouse become eligible for Medicaid while protecting assets for the community spouse. To qualify, the annuity must be: irrevocable, non-assignable, actuarially sound (payments must be completed within the annuitant's life expectancy), and equal payments with no deferral. The state must be named as the primary beneficiary up to the amount of Medicaid benefits paid. This is a complex area of elder law and requires an attorney who specializes in Medicaid planning.
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When Selling Your Annuity Payments Makes Sense
An annuity is designed to provide long-term income. But life does not always cooperate with long-term plans. There are legitimate situations where converting future annuity payments into a lump sum today makes more financial sense than continuing to receive installments.
| Situation | Why a Lump Sum May Help | Considerations |
|---|---|---|
| High-interest debt | Paying off debt at 20%+ APR with future payments you are receiving at a lower implied return is a clear mathematical win | Compare the cost of the debt to the discount rate offered by the buyer |
| Medical emergency | Immediate large expenses that monthly income cannot address fast enough | Get multiple quotes. Do not accept the first offer under financial pressure. |
| Investment opportunity with defined window | A real estate purchase or business opportunity with a time-sensitive closing | Evaluate the expected return of the investment against the discount rate |
| Financial situation fundamentally changed | The annuity was set up when your life looked very different | A partial sale may serve you better than selling everything |
| Annuity is a poor fit for estate goals | Life-only annuities pass nothing to heirs | Selling and reinvesting in estate-friendly assets may better serve your goals |
If you sell annuity payments through a licensed buyer, the transaction must be court-approved in most states, which provides an independent review of whether the sale is in your best interest. At MySettlement, we handle the entire court approval process on your behalf.
Frequently asked questions
What is the difference between an annuity and life insurance?
Life insurance pays a death benefit to your beneficiaries when you die. An annuity pays a living benefit to you while you are alive. Both are products sold by life insurance companies and both offer certain tax advantages, but they serve opposite purposes. Life insurance protects your family against your early death. An annuity protects you against outliving your money.
Can I lose money in an annuity?
It depends on the type. Fixed annuities, MYGAs, SPIAs, DIAs, and QLACs all protect your principal. Fixed indexed annuities have a 0% floor, meaning you cannot lose principal due to market performance (though you can lose to inflation and fees). Variable annuities carry genuine market risk and your account value can decline significantly. Surrender charges can also reduce your value if you exit early.
Are annuities a good investment?
Annuities are not investments in the traditional sense. They are insurance products designed to solve specific financial problems, primarily the risk of outliving your income. They are a good fit when guaranteed lifetime income, tax deferral, or principal protection is a priority. They are often a poor fit when liquidity is important, fees are high relative to alternatives, or the surrender period limits your flexibility.
What happens to my annuity if the insurance company goes bankrupt?
Your annuity is protected up to your state’s guaranty association limit, typically $250,000 in most states and $500,000 in states such as New York, Washington, and New Jersey. The guaranty association is funded by assessments on other insurance companies. This protection exists specifically for insolvencies. To verify your state’s limit, visit NOLHGA.com.
How are annuity payments taxed?
For non-qualified annuities, growth is tax-deferred and withdrawals are taxed as ordinary income on the earnings portion (LIFO basis). For immediate annuities, each payment is partially tax-free using the exclusion ratio. For qualified annuities funded from an IRA or 401(k), all withdrawals are fully taxable as ordinary income. There is a 10% early withdrawal penalty before age 59.5 on the taxable portion.
Can I sell my annuity payments for a lump sum?
Yes. You can sell all or a portion of your future annuity payments to a licensed buyer such as MySettlement in exchange for a lump sum today. The transaction requires court approval in most states, which provides an independent review of whether the sale is in your best interest. The process typically takes 30 to 45 days from offer acceptance to funding.
What is a 1035 exchange?
A 1035 exchange under IRC Section 1035 allows you to transfer the full value of one annuity contract directly into another annuity contract, tax-free. The exchange must be direct. Funds cannot pass through your hands, and the owner and annuitant must remain the same. A 1035 exchange is the right move when you find a significantly better annuity product and want to switch without triggering income tax on accumulated gains.
What is the best age to buy an annuity?
There is no single answer. Immediate annuities typically make the most sense in your late 60s to early 70s, when monthly payments are meaningful relative to the premium. Deferred annuities for accumulation can make sense at almost any age if tax deferral and guaranteed income are goals. QLACs are most useful in your 60s, before RMDs begin. The right answer depends on your income needs, tax situation, and overall financial picture.